Financial services

How do banks make their money?

The key aim of most banks is return on equity, i.e. how much money does a shareholder get back for every pound he puts in. Some  may not have shareholder returns as a driving force but they are probably still extremely interested in their version of this number. It is a ratio; which we analyse one half at a time.

Income

Banks get their income in two main forms.

1. Net interest income; the difference between the interest charged on loans and the interest paid on deposits. For a credit card bank (e.g. Capital One in the UK) this is the difference between the interest charged to their customers on their credit cards and the interest paid on money borrowed from other banks in the inter bank market. For a traditional mortgage bank such as Abbey National or Alliance and Leicester the interest income would be the difference charged on mortgages and the interest paid to the savings and current account customers. In theory one could have “savings only” banks but these are not economically attractive as there is an upper limit to what can be earnt from savings. For example in the US at the time of writing the Federal base rate is 2.75% and it is virtually impossible for banks to offer savers rates of 0% or below. Thus the most a “savings only” bank could make is 2.75%, which is the margin the “savings only” bank could get lending the savers’ money in the interbank market to other lending banks. Lending interest rates are pretty well unbounded (subject to usuary laws in some countries) so although FED rate is 2.75% banks could charge 10%, 20%, 50% for a loan if a customer is desperate enough to pay it. Hence lending is what really gets banks excited and represents a large proportion of their net interest income.

2. Non interest income; This can come from fees charged to customers for services or trading earnings (i.e. making money by buying and selling financial instruments). For investment banks non interest income is a much greater proportion of their earnings than commercial and retail banks. In commercial and retail banks quite a bit of their fees are tied up with lending; examples are
Loan arrangement fees
Collateral valuation fees
Credit card monthly charges
Mortgage redemption fees

Income is all very well but how much equity is required to generate this income? In bans all very well but how much equity is required to generate this income? In banks the equity is required to fund two concepts.
Physical

The staff, buildings and computers that are needed to win and retain customers. Overall this is a relatively small amount of money hence the proliferation of organisations offering credit cards, loans and mortgages to individuals.
Loan Underwritting

Lenders are obliged to put up a proportion of any money lent to fund a loan.  The proportion required depends on the riskiness of the loans, i.e. the probability that the loan is repaid on time (if at all). This is, relatively speaking, a large number.

When a loan goes bad, the bank has to devalue the asset in its balance sheet and take the write down as a cut in profits. When combining the income expected from a loan with the equity required for the loan, bankers use a concept called risk adjusted return on equity. This gives the expected return factoring in the probability that the loan will go bad. (This is achieved by reducing the expected income from the loan by the probable amount of money lost from the loan going bad).

The skill in banking is getting loans that are priced correctly in terms of interest rate and fees to reflect the risk the bank is incurring. It is easy to lend money with a low rate of interest and hence win market share; it is much harder to identify the customers thatomers that will successfully survive economic recessions and so be able to repay the loans.

If an external person wants to understand what sort of bank they are dealing with they have to go to the financial accounts and compare numbers with those in the financial statements of other banks. Interesting numbers and ratios would be:

1) Net interest income as a % of loans (this gives a feel for the average interest rates the bank is charging for its loans).
2) The amount set aside for provisions (this gives a feel for how much of the loans will go bad in the bank’s opinion)
3) The amount of customer deposits versus customer loans (if these balance then the bank is neither lending nor borrowing much in the scrooge like inter bank markets).